AOL said it would sell over 800 of its patents and related applications to Microsoft, and would grant Microsoft a non-exclusive license to the patents it retains, for slightly over $1 billion in cash.
AOL's shares jumped 37 percent to $25.16 in trading before the bell on Monday. They closed at $18.42 on Friday on the New York Stock Exchange.
The Internet company said it plans to return a "significant portion of the sale proceeds" to shareholders.
AOL will continue to hold over 300 patents including advertising, search, and mapping, and said it received a license to the patents being sold to Microsoft.
"This is a valuable portfolio that we have been following for years and analyzing in detail for several months," Microsoft's General Counsel Brad Smith said.
Last month, media reports said that AOL had hired Evercore Partners after being pushed by activist shareholder Starboard Value LP who believed the company's patent portfolio could produce more than $1 billion in licensing income if properly monetized.
The transaction, which is expected to be completed by the end of 2012, includes the sale of an AOL unit on which AOL expects to record a capital loss for tax purposes.
Evercore Partners and Goldman Sachs acted as financial advisors to AOL. Wachtell, Lipton, Rosen & Katz and Finnegan, Henderson, Farabow, Garrett & Dunner acted as legal counsel.
If the deal falls through, Microsoft will pay AOL a termination fee of $211.2 million, AOL said in a regulatory filing.